Tuesday, January 11, 2011

Are Rates of Return Really Down? No.

When stocks decline in value, people tend to panic.  But overall, the markets have done well over the years, despite setbacks.  The effects of the " crash"   of 2009 have largely recovered.

As I noted in my previous post, there is no shortage of nay-sayers these days, decrying the economy as "broken" and saying we are in a "new era" of financial affairs and that nothing will ever, ever be the same again.


Unfortunately, this sort of Emotional Thinking is what got us into trouble in the first place.  No doubt the naysayers of today were the same exuberant thinkers of five years ago.  And you can't blame them for being naysayers today, as they invested at the worst possible time and lost it all, most likely.

Taking a bi-polar approach to investing - irrational exuberance followed by unnecessary pessimism, is not a very rational way to invest.  If you do this, you will be forever buying high and selling low and losing money.

As I noted in another post, I know some retirees who panicked when the market crashed in February 2009 and "sold it all" and bought bonds.  They were convinced that the market would crash further and they should "get out now, while they still could!"  What they did instead was to lock in their losses.  The losses of February 2009 are a permanent part of their portfolio.

Has everything changed for good?  Did most of us "lose our shirt" in the market?  Hardly, and for several reasons.

1.  Overall Rate of Return:  Despite numerous crashes, recessions, setbacks, "Black Friday's" or whatever, historically, the market has done well - for over a Century.  As the table below illustrates, over the last Century, the market has returned over 10% on average.  Even during the worst decade on record, the overall rate of return was essentially zero, which during a decade of deflation is not to be unexpected.  So the idea that one negative event will forever change our economy is not only stupid, it has been proven wrong, over and over again.

Stock Market History of Returns

Decade Average Return Per Year
1900s 9.96%
1910s 4.20%
1920s 14.95%
1930s -0.63%
1940s 8.72%
1950s 19.28%
1960s 7.78%
1970s 5.82%
1980s 17.57%
1990s 18.17%
Over the last Century, the market has consistently returned an average of over 10%

2.  Losing Phantom Equity is Not a Loss:  As I noted in another posting, many people who never lost a penny during the recent downturn got on TeeVee and started whining about how they lost money.  One fellow, who bought a house for $250,000 and saw it zoom up to $500,000 in value in an overheated market, complained that he "lost money" on his home because it was only worth $250,000 now.

Come again?  You buy a house for $250,000 and it is worth $250,000.  How is that "losing money" at all?  At worst it is breaking even.  Until you "cash out" and create a realization event you can't lose phantom equity.  Of course, a lot of people caved-in to weakness and weak thinking and took out second or third mortgages on their homes using this "phantom equity" and are now upside-down.  But that is not losing money but merely spending it.

3.  Invested Value versus Market Value:  In a similar vein, it is tempting to look at your portfolio in February 2009 and compare it to, say, February 2008, and cry in your soup.  Your investments may have lost nearly half their previous market value!  Mine were down 30% or more!

But... you have to look at the overall picture.  For example, one account we had went from $120,000 in value at the peak, down to $80,000 in value.  A $40,000 loss!  Right?  Well, not exactly.  You see, the initial investment in that account was about $45,000 about 10 years prior.  So even at the depths of the "economic downturn" the account was nearly double in value.   And of course, since then, it has recovered to its previous levels, and thus is showing a very healthy rate of return overall.

Did we "lose money" due to the crash?  Um, not really, as you can't "lose" phantom equity, as I noted above, unless you create a realization event - you cash out.  And one reason I didn't cash out at the time was that I realized that it would be the worst thing I could do.  After all, at the time, stock prices were at their nadir and the best thing you could be doing would be to BUY more stocks!  So if I cashed out, I would just have to put my money back in.

If only I had $100,000 to invest in AVIS in February 2009..... it would be worth well over a million dollars today.

* * * 

The point is, if you are going to invest in stocks or mutual funds, or even Real Estate, you have to do it for the long term.  People who want to buy and sell and make large profits in a short period of time usually get creamed, as they are doing little more than gambling. 

And like in any good Casino, while there may be one or two big winners, they are legions of losers to offset those wins.

If you want to accumulate wealth, you have to work at it for a long time - have a positive cash flow and spend less than you make and save.  Compound interest and time are your friends, and over the years, your wealth will increase.

It is frustrating, when you are young and starting out, as it seems that savings don't accumulate very fast.  And it is tempting to look for "quick fixes" or schemes to make a lot of money in a hurry.  But they rarely, if ever, pan out.

Invest rationally, for the long-term, and don't be spooked by downturns or become euphoric during raging markets.  And stop taking investment advice from people who shout at you on the Television or folks in clown suits.

Chances are, if you invest carefully and wisely, diversify your portfolio, and move investments to safe harbors as you get older, you will do OK.  And that is all that most of us can hope for.

And it ain't such a bad deal, quite frankly.